Enrich Your Future 41 & 42: DIY Investing or Hire an Advisor? How to Avoid the Costliest Mistakes

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy com, continuing my discussion with Larry swedrow, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in Episode 645, now Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically we're going to be talking about chapter 41 A Tale of Two strategies and the final chapter, chapter 42 how to identify an advisor you can trust, Larry. Take it away,

Larry Swedroe 00:37
right? So it was the best of times. It was the worst of times. Probably the most famous words in all of literature. They're the opening lines of Charles Dickens, A Tale of Two Cities, which is all about, of course, the French Revolution. However, these words apply, I thought when I wrote this book just as much to the world of investing. For active investors, it's kind of the worst of times, because 20 years ago or now, it's 27 years ago when I wrote my first book. At the same time, Charles Ellis published his famous book, which is something like in its eighth edition. Now I've only had second editions of books, not eight. But he found in 1998 that about 20% of active managers were generating statistically significant alphas or out performance on a risk adjusted basis, before taxes, some for most people are taxable investors, unless you're endowment or a pension plan. Then, since taxes are the largest expense active investors face, if you're taxable, it's probably with something like 10% and as we discussed here, it certainly meant that you could outperform but Ellis called it the losers game because the odds were greatly against you, in the same way you can win in the casinos in Las Vegas or Macau, but the odds are also greatly against you, so it's okay to have a small entertainment account, take a trip for A weekend, and then maybe for some people, losing 500 or 1000 bucks, that's fine, and they had a good time. For other people, maybe 100 bucks might be the limit. And unfortunately, it wasn't that long, just 13 years later, which is now 14 years ago, faume and French famously wrote a paper showing that only 2% of active managers were now outperforming on a statistically significant basis. You know, that's 49 to one odds against you, and that was before taxes.

Andrew Stotz 02:59
How like were those studies? Were they pretty similar? I noticed that you mentioned before taxes is that they're both basically done on the same four

Larry Swedroe 03:07
taxes. And subsequent studies have pretty much confirmed that there was another study I forgot. Who did it? It's something like 2% also. And as Andrew Birkin and I explained in our book The Incredible Shrinking alpha, we explain why the trend was getting worse for active managers and why it was likely to continue to persist in getting worse, because the people who are quitting active management were the people likely who didn't have the skills or were unlucky. Either way, they leave. And if you have, if you are less skilled, there's less victims for the active investors to exploit. And they need victims because it's a zero sum game, even before expenses. So people are leaving, the competition is much tough. 30 years ago, you got out of school, maybe you had a Literature degree, and you went to work for Goldman Sachs, and they trained you to be a security house. Today, you need a PhD in Nuclear Physics, let alone and finance to go work for some hedge fund that's who's managing money today, so their competition is and the databases are much tougher, and you have artificial intelligence helping everybody, but clearly it's going to get harder and harder for active management to win, the more people leave the game and keep switching. Now we really want to keep this a secret, that it's a loser's game, because we do need some naive investors to continue to be the suckers at the poker table, because that we need active managers their price discovery efforts to keep the markets efficient and pricing. Now what's important to understand is. This in the 1950s the markets were still pretty efficient. The research showed active managers were not outperforming generally, and there wasn't persistence of out performance. And there was only about 100 mutual funds today, there are 10,000 more than twice as many as there are stocks, when you count the all the ETFs. So you know, the industry could shrink 90% and we'd still would find, I think, the markets highly efficient, especially because the remaining people would be the Warren Buffett's, Peter Lynch's citadels, Renaissance technologies. And they would keep markets highly efficient. So these are the worst of times, I think, for active managers. On the other hand, it's the best of time for the passive or systematic investors, is the term I like to use. So using quant strategies that are systematic, replicable and transparent, like those of dimensional fund advisors, Avantis BlackRock, even Vanguard uses systematic strategies, not just pure index funds, which we've pointed out, are perfectly okay vehicles, but they do have some negatives that can be either minimized or eliminated by intelligent design, including patient trading and the cost of literally gone to zero. Who can own an S and p5 100 found or a total for virtually or either zero expense ratio? And you have many vehicles. You know, when I started investing with dimensional, if my memory is right, in 1995 their small value fund, which is a systematic strategy, was like 92 basis points. I think it's in the 20s. Now, caught you've got better vehicles, more sophisticated, updated using new research, better trading strategies, and the costs have come way down. So for active managers, it's the worst of times, and for passive or systematic strategies, it's actually the best of times.

Andrew Stotz 07:17
And I was just looking online, and the ICI data shows that actively managed funds were about 49% of total funds as of April of 2025 versus passive at 51 so I think it was two years ago, or a year and a half or so that active actually exceeded passive for the first time, which is one of The other way around. Passive exceeded, yeah,

Larry Swedroe 07:42
that's roughly 5050, now from studies.

Andrew Stotz 07:45
And you know, I'm reminded of when I was a broker. We that the EU came up with something called method two, and it was a way of trying to deal with the costs of funds and ETFs, and they came up with all these regulations to try and what it ended up happening is that they they pretty much increased the cost through those rules and regulations, and they destroyed the independent research providers that they thought they were propping up. So the unintended consequences were incredibly destructive, in my opinion, for the industry in Europe. But what fascinating is, you just take one crazy man, John Bogle, yeah, with one very counterintuitive against an American idea, yep. Yeah. Very different, you know, I am very different from what was happening. He challenged the convention. He overturned it, and he basically by just that movement of one man in a capitalist society that allows you to bring any product, any service, in any way, into the market, single handedly, that man probably reduced fees that people paid from when he started till today, by at least 50% on average that people pay

Larry Swedroe 09:06
Andrew. You know what's amazing? I mentioned that Ned Johnson, who was the chairman of fidelity, when Bogle introduced Vanguard's first S and p5 100 fund, he called it unAmerican. Why would anyone want to accept average returns? Well, Johnson was the fool because he was confusing market returns with average returns. If you get market returns by definition, you have outperformed the average active investor, because you've got lower costs than they do. And if you own the market, they collectively have so they have the same gross returns, but much lower net return. And today, fidelity is one of the world's biggest provider of low cost index funds.

Andrew Stotz 09:55
Yeah, there's two things I want to mention just before we leave this topic in. The first one is. About tax, and the second one is about the factors. So, you know, a person can own, as you mentioned in this chapter, a fidelity as an example, fund that's zero, you know, and there's others that are, you know, the fees are so close to zero for just a total market fund. But then, as you've mentioned in here, there's also factors within that there's factors like value, size, momentum, profitability, quality, low volatility, these types of factors. So that's, you know, one thing I just wanted to mention. But the other thing I just want to understand is, when we talk about taxes, what do you when you say, not considering the negative impact of taxes, are you talking about the impact of taxes within the fund as they're buying and selling? Are you talking about the tax impact when the person who owns it is selling

Larry Swedroe 10:47
it? You're talking about both, because actively managed funds have much higher turnover, so they realize more short term gains, more long term gains. Now that has been mitigated to a great degree by the introduction of ETFs. So I always tell people, if you're going to invest, at least in the US, in taxable accounts and equities, no question you should own ETFs. Now, ETFs are often, but not always, a bit cheaper than a mutual fund. Avantis, for example, charges the same, but others are a bit cheaper. Vanguard, I think, is the same, but at any rate, you do have a bit more expenses, because when you trade a mutual fund, it's at the nav so there are no trading costs there. You may pay some small commission, but with ETFs, you do have the bid offer spread, but that's, you know, it is an expense that you can avoid by owning a mutual fund. Well, you would

Andrew Stotz 11:56
have had that bid offer spread if you were building a portfolio of 10 or 20 stocks, you would have had that bid offer spreads with those different 10 or 20 stocks. Times,

Larry Swedroe 12:04
10 times, not once, yep, but in an IRA, you should never own an ETF. You should only own a mutual fund because you don't have the trading cost that bid offer spread.

Andrew Stotz 12:16
So let me go back to this for a second, just because many people don't understand how an active Fund Manager works. And let's talk about an active fund for a moment. When they're buying and selling, I'm assuming that they're paying, you know, people would assume, when they look at it like, okay, they bought a stock for 100 they sold it for 20, 120 they made a 20% return. They did that in three months because they're a good trader. Are they paying a tax on that 20 game?

Larry Swedroe 12:45
Yep, absolutely. So that, because they have to pass through the net gains at by the end, you know, during their fiscal year, which typically might run from October to October.

Andrew Stotz 12:58
So let's say for the fiscal year, they've done all of this trading, and they ended up with a 20% average capital gain. And they ended up with, you know, a certain amount of tax of that capital gain. How does the investor does that come in? What part of that comes in the nav versus what's, you know, fed

Larry Swedroe 13:19
through to us? You would get a 1099, it's called, it's a statement from your custodian, and it would show how much of your return was in the form of dividends, some of which can be qualified, and they're treated like, more, like capital gains. Some are non qualified, and that's treated as ordinary income. You have short term capital gains, which are treated as ordinary income. And if you live in California and you're a high bracket investor, you're paying 43% or so federal tax and maybe 13 or more percent California tax. So you're and then there's long over 50% of your return, if, on the short term gains have disappeared, and for the longer term gains, you're paying 23% roughly, plus the state tax. So you're going to give up a large percentage of your returns. Now, as I mentioned, ETFs, through some technical mechanisms, basically avoid most distributions. Most ETFs don't distribute any capital gains or very, very minor here's the thing, Andrew, most people don't know if, let's assume the average fund actively manages expense ratio 1% but because they're active, they have to sit on some cash. Let's for argument's sake, that's 10% of the portfolio as they're waiting looking for good ideas and stuff, right? Half? Have liquidity to meet demands of people redeem, etc. Well, today, cash is yielding. You say 4% and stocks, let's say have an expected return of 10 so you're giving away 6% on over the long term. Now, in a bear market, cash would help you, but on average, markets go up. That's one cost cash. Second costs you have are, of course, any bid offer spreads that are called market impact costs. When you want to move a large amount of stock, that's increased because there's much less liquidity today, as we have discussed. And so you not only have the bid offer spread, say it's 10, bid 10 and a quarter, ask for 1000 shares, but you want to sell 100,000 you may end up with an average price 10 and three quarters, and then the price drops right back to to 10, and you just paid away 7% in market impact costs. You know, market impact costs are significant. And then, of course, you have taxes, and those easily, collectively, could be three, 4%

Andrew Stotz 16:15
and can we go back to the tax for a second? So let's say that you get it. You get your 1099, statement. It shows what's portion is, you know, dividend qualified, unqualified, short term, long term, you have these components now that also means that that fund manager, through their activity has generated that either the dividend income from what they own or the short term and the long term capital gains, when they actually execute those trades throughout the year they're incurring and building that up. Are they paying tax on those trades?

Larry Swedroe 16:49
No, the mutual fund doesn't pay the tax. They allocate out the taxes to the ownership. Pro rata there. I may not remember this exactly, but Russ warmers did a study, pretty famous one in the early 2000s looked at this, and he found, as you would expect, because we, as we discussed, the average retail investor, the stocks they buy go on to underperform, and the stocks they sell go on to outperform? Well, somebody's got to be on the other side of that trade. Turns out it's professional investors, institutions, mutual funds. They are good stock pickers. The problem is they gain, let's say, 60 basis points a year from their active stock selection skills, they charge you 1% your cost of cash, he estimated at about 70, and your transactions costs were another 1% or so. So the average fund underperformed by one and a half percent or something like that, even though that was pre tax, even though the stocks they picked out perform.

Andrew Stotz 18:02
Was this the concept of active share? No,

Larry Swedroe 18:05
not active share. Okay, if you pick up my original book, you'll find rust formers, and you could dig up the stuff.

Andrew Stotz 18:12
Okay, fantastic. Well, let's move on. Let's move on. Before we do that,

Larry Swedroe 18:17
I want to end with the moral of the tail. Okay, do that one thing we haven't really covered. Sorry about that. By tales, not only has an analogy, but has a moral. So this one I write, when Dickens wrote those famous opening words, perhaps he knew that. Would it be applicable to all times. They certainly are applicable to investors today for the majority of those who continue to place their faith in the practice of active management, it has been the age of foolishness, the season of darkness and the winter of despair. However, for those who have adopted a passive investment strategy, that has been the age of wisdom, the season of light and the spring of hope. Wow, that's the moral of that tale.

Andrew Stotz 19:07
So what do you want? We want light and hope, yeah, all right. So chapter 42 how to identify an advisor you can trust,

Larry Swedroe 19:21
yeah? Well, when it comes to like home repairs, there are individuals like my son in law, he can fix anything. I can screw a light bulb in and screw a turn a screw in or bang a nail to hang a picture, anything beyond that, I know I will end up paying twice as much to undo the damage than if I paid a repayment in the first place. Right? So there are people have the skills, and they should try to do it themselves, and it obviously, then is likely true of investing the problem. Is that so many investors are overconfident of their skills and being able to pick stocks time the market, identify the best investment vehicles. And on top of that, you not only have to have all those skills, you have to have the behavioral skills to be able to set up your plan and then stay the course, avoid all of the biases we've discussed, like recency bias, tracking variance, or get regret because your portfolio underperformed the s p5 100, even though you decided you didn't want the s p5 100 because it's all in one risk, and it's had three periods of at least 13 years where it underperformed T bills. So you wanted to diversify, right? But even that's not enough, because a good wealth advisor, not just an investment advisor, not only helps you build a plan and choose the best investment vehicles that'll give you the best chance of achieving your life and financial goals, but you integrate that plan into a well thought out estate tax, insurance of all kinds plan and then helps you adopt over time as life events happen, changing those plans adopts to the latest research. 10 years ago, I wasn't investing in any alternatives. Now half my portfolio is alternatives, and having the knowledge and ability to do the due diligence understand how the world has changed is important. So those are all things investors should know. But I created a list here in the book of 11 commitments that advise investors should demand of an investment advisor. So when you go meet with them here, here we go. So number one, the firm should be able to demonstrate that it's guiding principles is to provide investment advisor services that are in the best interest of the client. In order to do that, principle number two is you should demand in writing that you that the firm is providing you with a fiduciary standard of care which is fitted the highest legal duty. It differentiates itself from the suitability standard which all people generally who work for investment firms like Merrill Lynch and Morgan Stanley their fiduciary responsibilities generally not to you, but to their firm. So let me just give a simple example of the difference. I worked at a registered investment advisor in the US all RIAs are required to be fiduciaries if I want to invest in an S and p5 100 fund, I'm required, say, to offer them Fidelity's fund, or Charles swaps Fund, which costs a few basis points. If I worked in Merrill Lynch, they may have or some insurance company, they can have an S and p5 100 fund that costs 75 basis points, and it's suitable, but clearly not in your best interest. I have talked to hundreds, if not 1000s of investors who work with those kinds of advisers, and none of them know the difference between the suitability of fiduciary sin, they all think they're required to give advice that's in their interest. So that's number two. Number three is the firm should put in writing that they're a fee only advisor, meaning the only one compensating them in monetary ways, is someone meaning their client. So you can't get a commission from anybody else because that commission could bias you. Obviously, I could tell a quick story. I was invited to be a guest speaker on this investment advisor here in towns radio show. I had to be very careful what I said, because he was work for insurance company, and his big thing was selling annuities. So I had to be very careful as a guest, I didn't want to, you know, be too impolite. But after the show, I said to him, said, Look, we're offering our clients the same investment product, without all these bells and whistles, which are just big expenses you're you know, and we charge 1% a year, and we're providing estate planning, insurance, all these other advices, and we act as a fiduciary. It. And the guy said, Well, why should I do that when I get an 8% commission upfront? And I said to him, how do you look yourself in the mirror? And that ended that conversation. I was never invited back as a guest, right? It's required of all registered investment advisors. They're fee only. Can't be anything else. You must disclose. The SEC requires them what's called the ADV, or investment advisory agreement, that all potential conflicts of interest are disclosed the firm, very importantly, should be client centric, okay, meaning they deliver sound advice that's only in the client's interest. It's unique to them. Okay, most importantly, or one of the key things, is their advice. They must be able to demonstrate to you that their advice is based on empirical, academic research, not their opinions, like, I think the market's going up, or this stock is going up. We've gone through the evidence on active management. So why would you choose someone who's doing that, you know, and stuff. Everyone people ask me, What do you base that recommendation on? I can show them. Here are the academic papers in my book with Andy Birkin, your complete guide to factor based investing 110 academic papers decided. As you know, in all my books, I cite the literature. These aren't my opinions. They're based upon what the research says. You want to make sure they deliver a high level of service. So they're working with a small number of clients, not 250 or whatever, that they have a team of experts who no one's an expert in all fields. Some are more knowledgeable about investing, some about taxes, some about insurance, some estate planning. And you want people who are giving you advice to have the professional certifications that say they are an expert in this. You know, in that advice, you want to make sure they develop a plan that's integrated, because investment decisions have tax consequences. They have estate planning tax consequences, things like that. You want to everything should be integrated, and how one investment impacts the rest of the investments and the whole estate plan, their plan should be goal oriented. Every investment should increase the chances of achieving your goal, and they should be required to show you why that's the case. So those are all things. If you can't get all of them, just walk away, because there are 1000s of good advisors who can provide those services. Oh, one other thing demand in writing to see that they are investing their personal money in the very same vehicles they're recommending. Now I wouldn't expect it to be the same asset allocation because they're a different person, different age, different job stability, different ability, willingness, and need to take risk, but I was always happy to pull out my Schwab statement and show them. Here's my investments. Now some people might not want to show them the dollar. Them the dollars. That's fine. Blank out the dollars, but you could see what the vehicles are if they won't show you what they're investing in. Wave goodbye.

Andrew Stotz 28:53
And is this a tough standard, a normal standard? You know what? I think it's

Larry Swedroe 28:59
very simple. If someone's not prepared to do it, why should you trust them? Yep, every one of those things should be there. Now it doesn't mean, for example, you may have an investment advisor who outsources the tax expertise to some attorney they work with. You know, that's fine, but I think it's best if all those resources are in house, because every decision, or many decisions, are integrated, and you have to make sure you're reviewing everything with each decision.

Andrew Stotz 29:32
You know, there was a time where this, all that you've just talked about, was not very commonplace and not regulated in the way that it is in the US and in fact, in markets around the world, particularly in Asia, that's not common. And in fact, you'll see that they really, not only has the regulator not gone where the US has gone on it, but you also have investors who say, I'll never pay for financial advice, you know? And. So it's the same thing, a little bit like trying to get independent research, where you do try to sell independent research to fund managers. Say, why? Why should I pay for that? I get it for free from a broker, right? Yeah, and it's a similar type of thing. It's very interesting. And you know, I'm wondering,

Larry Swedroe 30:15
the broker charges you the 8% commission product that was, you know what I pointed out to a friend of mine? You

Larry Swedroe 30:56
i He loved his broker because and then I looked at his returns and showed him he'd underperform for years. I said to him, those are the most expensive suit. I don't know what happened. Well, I think

Andrew Stotz 31:09
we caught most of that, but just you can wrap up that final point you were saying,

Larry Swedroe 31:13
yeah, let me get I'm trying to shut down some things, so let me see if I can shut this. Okay, alright, oh, wait, I can shut one more thing down because I was working on something else. Okay,

Andrew Stotz 31:35
so maybe go back to that, the that story, yeah,

Larry Swedroe 31:39
okay, oh, here we go. I'm

Larry Swedroe 32:12
all right, just up in the corner here. Now, weird? Yeah, you're not hearing me, huh? I

Andrew Stotz 32:18
hear you, and you're a little bit sketchy on the video side. Here we go. Let's see.

Larry Swedroe 32:40
Okay, we're back on. We are back all right, so you

Larry Swedroe 33:18
so, this is one of my favorite stories. I don't know what the story is, Andrew, let me try one other thing I'm going to sign off you.

Larry Swedroe 34:19
Uh, okay, I think that should do it. All right, yeah, all right, so I'll start, and I'll tell that story. So one last story to round this last chapter out. One of my favorite stories is this one. I had a friend who had a broker, and every year, I mean, he would rave about this guy, because he'd get tickets to the Super Bowl to you. Golf Championships, whatever. And I would ask him to say statements and stuff, because that boy I get to

Larry Swedroe 35:20
the expensive tickets he had ever gotten for free, he could have bought tickets online at StubHub or something for 1000s of dollars less than he actually paid for his free tickets because his performance was so bad and there was so much tax inefficiency,

Andrew Stotz 35:46
right? Yes, well, it's, it's incredible how easily people can be manipulated on that. And I see that. I see that in Asia a lot too, where private bankers and others are losing people a lot of money, and then they take them out for nice dinners, and they take, you know, get them all kinds of perks, and they Love it. And so they

Larry Swedroe 36:08
ask, what kinds of you

Larry Swedroe 36:32
perks, they are in Thailand, right? All right,

Andrew Stotz 36:37
I'm going to wrap this up so Larry, I want to thank you again for this great discussion, not only of this chapter, but of all, all 42 chapters, which has been incredible. I want to do a wrap up later on this, but I look forward to that final wrap up. But for listeners out there who want to keep up with what Larry's doing, you can follow him on x, and you can also follow him on his sub stack and on LinkedIn. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside.